We have written a great deal about the financial crisis and it is possible that this particular crisis has been solved. Basically by flooding the world with liquidity, putting money into the banks and guaranteeing a lot of things, the financial system can begin to function again.
So why is The New York Times running pieces such as Stocks Plunge 8% on Economic Gloom?
The answer is that making credit available is a necessary but not a sufficient condition for a prosperous economy. There is a phrase economists use — “pushing on a string” — to describe the limitations of monetary policy. It is relatively easy to use monetary policy to reduce demand, but it is much harder to use it to create demand. The Fed and the Treasury can make money cheap and available but they can’t make banks lend it or make people borrow it. Almost a year ago Business Week ran a piece that described the problem:
Four years ago, an economist from the Federal Reserve Bank of St. Louis, Jeremy Piger, demonstrated the problem that’s giving Fed Chairman Ben Bernanke and his crew such a tough time. Piger showed that it’s a lot harder for the Fed to boost growth by cutting interest rates (as it seeks to do now) than it is for the Fed to slow growth by raising rates (as it tries to do when the economy is overheating).
Specifically, Piger found that in the two years following a one-percentage-point increase in the federal funds rate, quarterly GDP growth fell 1.21 percentage points. In the two years following a one-percentage-point cut in the funds rate, quarterly growth rose 0.53 percentage points.
Slowing growth? Easy. Stimulating it? Hard.
This is not just a theoretical issue. Paul Krugman, best known popularly as a New York Times columnist, is an economist who just won a Nobel prize for his work related to trade, wrote a technical paper back in 1998 entitled Japan’s Trap, which attempted to understand why Japan was in a major recession even though interest rates were near zero and the Bank of Japan had expanded the money supply briskly. Here is how he put the question:
Japan poses a problem for economists, because this sort of thing isn’t supposed to happen. Like most macroeconomists who sometimes step outside the ivory tower, I believe that actual business cycles aren’t always real business cycles, that some (most) recessions happen because of a shortfall in aggregate demand. I and most others have tended to assume that such shortfalls can be cured simply by printing more money. Yet Japan now has near-zero short-term interest rates, and the Bank of Japan has lately been expanding its balance sheet at the rate of about 50% per annum — and the economy is still slumping. What’s going on?
Japan’s efforts to reinvigorate its economy and its stock market have so far foundered for fundamental reasons. Japanese policy makers have followed the advice of Keynesians while ignoring the wisdom of Keynes himself. Since 1992, 60 trillion yen ($600 billion) worth of public works spending, the ultimate Keynesian stimulus, has done no more than to recycle excessive private savings into Japan’s depleted spending stream. Meanwhile, the deflationary momentum, so much feared by Keynes and created by the lingering effects of the Bank of Japan’s overly tight monetary policy has not been broken. Until Japan’s consumers are convinced that goods will cost more next year rather than less, the economy will remain chronically depressed.
This strikes us as speaking to the core of the problem. Although many commentators have said that individuals who imprudently bought houses they couldn’t afford with mortgages they couldn’t afford to pay deserve a share of the blame, we think the situation is a little more complex than that.
These consumers were not irrational; the old model of saving up a substantial down payment no longer worked because the prices of houses were rising faster than families could save. So individuals made the prudent decision to grab what they could when they could do so because only by being “on the escalator” of rising home prices could they hope to have a house for their family.
Now the psychology has shifted. Instead of feeling that they must rush to buy a house because they won’t be able to afford the same house next year, people feel they can wait.
Right now, people have no reason to borrow money. One of our friends is a real estate developer. He built out the infrastructure of a 100-house community and built several model homes. Now he would love to borrow money and finish building all the houses, but he won’t do that unless someone buys the houses. It is very likely, though, that we currently have a surplus of houses if you define it against the number of people who can legitimately afford to own a home.
Especially in this type of situation, where the very core of the problem had to do with easy credit, we find ourselves stuck. Our friend can’t sell his houses because there is no demand. Cheap money helps a bit, but the reason we had to go to zero-down-payment, interest-only and teaser-rate mortgages is because just lowering the interest rate was not sufficient.
So the Federal Reserve can invest trillions in the banks, but if they set up a responsible loan criteria — say a 25% down payment, a verifiable income, no more than 25% of income spent on housing, a FICO score over 750… even if the interest rate is zero — there will probably be very little demand because the vast majority of people who meet these criteria already have houses. So they won’t buy our friend’s new houses unless they can sell their existing homes. Yet they won’t be able to sell their homes because, in a circular manner, all the people who meet the criteria and would be able to buy their homes already have homes.
Now there are always new people coming to meet the criteria as their savings or incomes rise — but there are always people who pass away or meet misfortune and must give up their homes. Now we are not urging any of the following as a policy prescription, but if the goal is to get home builders back to work then the only policy changes available to increase the demand for housing would most likely come in one of these three areas:
1. We can allow in immigrants or foreign purchasers. If we have a surplus of housing, one way to deal with it is to bring in people who will absorb that surplus. Of course these will have to either be entrepreneurial immigrants who create their own jobs or wealthy immigrants or investors who qualify to buy a house without a job.
2. We can increase general prosperity. If we increase the number of Americans employed or increase the incomes of Americans, more would qualify for the mortgages and there would be more demand. But increasing employment and average income are not easy to do. Many of the tools we have to do this such as increasing education can take many years to pay off.
3. Finally we can make it easier to buy homes. If we offer no-down-payment, interest-only loans, with an ability to add interest to principle if you have a tough month, and we give this to people without regard to FICO scores and with no attempt to verify income, our friends will have customers for their real estate development as millions of people who can’t afford homes will now be able to buy. Of course the default rate on these mortgages will be very high and so we will be right back in the situation we started with.
So the stock market is telling us that even great liquidity won’t provide an easy solution to the problem of boosting demand.
As As we mentioned in a piece in Pundit sister publication, PRODUCE BUSINESS, J.P. Morgan’s father taught him that surpluses would happen from time to time but that, in the long run, the enormous growth of America would absorb these surpluses.
That is a statement both fair and true. As the world seeks to avoid the struggling that a major recession or a depression involves, however, it does remind us of another statement by John Maynard Keynes:
…this “long run” is a misleading guide to current affairs. In the long run, we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again.